For investors focused on long-term capital appreciation, the challenge in today’s equity markets is to maintain adequate growth potential while keeping valuations reasonable. By weighting a portfolio using metrics other than market capitalization, an alternative weighting strategy may offer a solution to this challenge.
Today’s Valuations Are High, but Not Excessive
An examination of a range of valuation metrics for the S&P 500 Index shows that they are far from aligned. Exhibit 1.These ratios cover metrics from the top line of the income statement (sales) to the bottom line (earnings). Most are in-line with historical averages or above, but one measure stands out for being more than one standard deviation above its historical average: price-to-sales (P/S). Exhibit 2.
Investors need to go back to the dot-com bubble to find an S&P 500 P/S ratio as high as the one we’re seeing today. Of course, P/S simply reflects how much investors are paying for each dollar of company sales, which implies that investors are paying more per dollar of sales than they are for earnings. We prefer using sales (i.e., revenue) as a valuation metric because it sits at the top of the income statement and, as a result, has less potential to be manipulated compared with metrics like earnings that appear farther down the statement. In addition, our prior research has shown P/S to be a strong indicator of the potential for future long-term returns in the U.S. large-cap equity market, substantiating the old adage about how buying at lower valuations can lead to stronger long-term returns.
A Rules-Based Approach that Balances Growth Potential and Valuations
Equity investors seeking to achieve return objectives have several options available to them—but not all may be suitable for those who are sensitive to valuations. Many have flocked to passive management for U.S. large-cap exposure, an approach that offers a low-cost alternative to active management, but does little to address the valuation issue. Active managers, meanwhile, have the potential to seek out undervalued securities and weight their holdings accordingly, but investors first need to identify those managers and vet their processes.
An alternative solution is to adopt a rules-based approach that uses corporate revenue rather than market capitalization to weight securities, or fundamental analysis to select them. Looking back, revenue weighting the S&P 500 Index has offered a history of reasonable valuations. This is especially true today as revenue trades at a 62% discount to the broader market, which is the widest discount in nine years.
While we know that valuation multiples themselves are not a catalyst for future positive performance, attractive valuations combined with favorable growth potential can offer improved upside potential over the long term. Revenue weighting the S&P 500 Index offers just that ̶ attractive sales growth in relation to its current valuation, which is far from stretched. Drawing comparisons between revenue weighting and other approaches underscores its relative attractiveness regardless of whether you believe that the market has room for further multiple expansion.
When compared to:
- The market, revenue weighting offers noticeably higher sales growth for nearly a third of the P/S.
- A value index, revenue weighting offers three times the amount of sales growth for half the P/S.
- A growth index, revenue weighting offers a respectable level of sales growth for nearly a fifth of the current multiple. Exhibit 3.
In conclusion, a revenue-weighted strategy can help bring valuation ratios back in line for both blend and growth investors while maintaining above-market growth characteristics. And for value investors, it offers significantly more growth potential at lower valuations. While it is difficult to find pockets of the U.S. large-cap equity market that remain undervalued by classic measures, all investors may benefit from looking beyond traditional means for optimal solutions to build robust portfolios today.
OppenheimerFunds is not undertaking to provide impartial investment advice or to provide advice in a fiduciary capacity.
Alternative weighting approaches (i.e., using revenue as a measure), while designed to enhance potential returns, may not produce the desired results.